The dawn of a new century for real estate investment trusts.

Remember last year's Y2K concerns?

According to James Sullivan and Louis W. Taylor, two senior real estate analysts at Prudential Securities Inc., the real estate world is about to experience an upheaval that could only be compared to the Y2K threat. And the reason is the new REIT Modernization Act (RMA), which will go into effect in January.

Taylor and Sullivan were host speakers at last Thursday's Prudential Securities luncheon, which featured a discussion on how the RMA will affect the real estate community in the immediate future. Both analysts agreed that the Act will create a wealth of previously unforeseen opportunities for real estate REITs by allowing them to have taxable REIT subsidiaries (TRSs). Growth rates will accelerate, cash profits will increase, investment risks will be taken, but at the same time, Sullivan is worried that the RMA will encourage unhealthy levels of new construction, while Taylor was convinced that many of the smaller, more unstable companies will be wiped out of existence as a result of high-risk ventures and unsound business plans.

In general, the analysts' outlook was optimistic. According to Taylor, RMA will allow REITs to have more flexibility in dealing with condominiums, corporate housing, and merchant building. Previously, government restrictions discouraged REITs from leasing out the space directly, because the income gained as a result of these transactions was perceived as "tainted". Now, by investing in TRSs, real estate REITs will be finally able to cash in on their properties. As to the merchant building, according to Taylor: "A TRS completely changes the landscape. With its capital access, extensive relationships, and no restrictions on its holding period, REITs could become very formidable competitors in the merchant building segment."

Sullivan was a bit more restricted in his enthusiasm. "In merchant building, new development can be risky," he warned. "It is an undertaking advisable only for stable companies, with stable cash flow. And it has been my experience that whenever you see REITs aggressively pushing merchant buildings, those are the ones they don't want."

Sullivan, whose area of expertise involves the hotel sector, health care facilities, and strip malls, was a bit more concerned in general about the long-term effects of the REIT Modernization Act. "My biggest worry," he said, "is that the RMA may drive construction to unhealthy levels, decreasing the value of existing properties in the process." He was particularly concerned about the RMA's effect on the hotel industry. "There is an excessive rate of new development for limited service products," he said. "We've already gone through a similar period in the 1990's. In the hotel sector the rate of new supply was unchecked, and some developers had to cut down on dividends, because of excessive levels of new construction. People have to remember that markets can change and put even big-name companies out of business."

At the same time, Sullivan said he believes that many of the smaller hotel developers will soon be out of business anyway. "The trend has been for REIT hotels to increase, both nationally and internationally," he said. "Over time, there will be three or four hotel operators left, with Hilton or Star taking over everyone else when the financing environment is right."

A similar trend may appear in the commercial property market, if Taylor's predictions hold true. According to his projections, many of the larger companies on the market, such as Mack-Cali Realty and Reckson Associates, will take advantage of the opportunities presented by the RMA, encouraging smaller companies to join, and eventually taking them over. "In the next sixth months, the office market is going to grow and change," he promised.

When it comes to the residential sector, however, Taylor is less confident about the direction of future trends. "In the apartment business," he explained, "the big companies don't really have an interest in the smaller ones. Some of the reluctance has to do with the apartment types, or the kind of property it is. I would look for them to go private."

Taylor also had some good news concerning retained cash flow and growth rates for real estate REITs. "A TRS allows the subsidiary to retain profits and cash flow in the subsidiary," he said. "This could have a very real impact on a company's overall retained cash flow." As to the potential growth rates, he explained that high-risk business transactions would increase the earnings growth substantially for successful companies, but will become death sentences to others: "There are more than 200 public real estate companies with a wide disparity of business plans and management talents. We believe there is a zero probability that all 200 will successfully implement TRS business plans. We expect this to create more merger and acquisition opportunities, more management dismissals, and further consolidation of the business."

The analysts used the European Property Fund and the JPI Properties of Dallas as examples of sound business strategies when it comes to aggressive REIT investments. "The European Property Fund has 16 investors, and they always have a ready buyer for every project they undertake," Taylor said. "And the JPI Properties eventually sell everything they hold." The key to success, apparently, is in basing everything on sound business practices, as opposed to hopeful thinking.

The REIT Modernization Act will become effective on January 1. According to Taylor, "For real estate companies, it could very well be the true start of the next millennium."